Cheap Options — Look Out!

Notwithstanding Tuesday’s action, the
mood has darkened on Wall Street
since May 21, when spirits were
running high. The Nasdaq quickly slipped
12%. Is this just a brief pause?
Or are we in for another plunge?

No one knows for
sure. But one thing I can tell you is
that the options market is sending a message that all is well — no big
sell-off is expected. How is it saying
that?  Because options are cheap.
Only two months ago they were expensive. Now
the options on most stock and stock indexes are at very low implied volatility
levels. This implies smooth, quiet
sailing ahead for the markets.

The problem is, this
message cannot be trusted. In fact,
history teaches us that it is wiser to go contrary to this message and prepare
for a big move in the markets, one way or the other.
Why? Because every time implied
volatility gets extremely low, it’s never long before some volatile price
action ensues. History also teaches us
that while this move is sometimes upward, it is more often downward.

So, contrary to my
article in the just-released Informer (not the cover article, but the one
inside — about covered writing) options should be bought right now, not sold.
(At the time I wrote the article, options were expensive.
That’s how swiftly implied volatilities have come down!)

For those with stock
portfolios, this situation favors the buying of puts to hedge your stock
holdings.

It also suggests the
buying of speculative puts if you believe the market is headed down again, or
the buying of straddles, if you’re not sure of the direction but just want to
place the odds in your favor by buying cheap options.
I would suggest going all the way out to the September, or even farther.
Not only does this give you more time, it also puts you into options that
will expand more when implied volatility goes back up.

Options are cheap
now in all the big-name favorites: Microsoft
(
MSFT |
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, IBM
(
IBM |
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, Apple Computer
(
AAPL |
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, Intel
(
INTC |
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,
America Online
(
AOL |
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, the Nasdaq Holders Trust
(
QQQ |
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, etc.

Especially cheap
options can be seen right now in Agilent
(
A |
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, America Online (AOL), Enzon
(
ENZN |
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,
Goldman Sachs
(
GS |
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, IBM, Int’l Game Tech
(
IGI |
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PowerRating)
, and Nvidia
(
NVDA |
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PowerRating)
. 
I’d have to say that America Online and IBM are screaming buys (see AOL
Volatility chart below).

Also noteworthy is
the fact that historical put/call volume ratios on the OEX are on the verge of
giving a sell signal as they did in February (see OEX chart below).

Personally, I’m
looking to bellwether Microsoft as an indication regarding the short-term
direction of this market, as this stock is not being moved so much by news these
days, but more by general market sentiment and money flow.